Monday, August 5, 2013

Prices of stocks have increased a lot in 2013. As a result, many dividend investors are shunning purchases, citing high stock prices. This means that they are not reinvesting dividends, and keeping any fresh portfolio contributions in cash. The issue with this strategy is mostly psychological.

These investors are hoping for a correction, that would make investments affordable again. They believe that they are better off waiting for better prices, rather than buy shares at or above the maximum prices they are willing to buy at.

First, an investor can easily afford to wait for attractive valuations. However, it would be difficult to hold on to your cash when it earns practically nothing, but the positions you had set your sights to balloon in value, increase distributions and enjoy rising profits. From a psychological point, you might admit defeat at some point, which unfortunately could be too late.

In general, individual investors are really bad at timing market moves. As a group, they tend to sell near bottoms, and finally give up and buy at the top. This is why most individual investors are better off simply buying and holding stocks, and not making many investment decisions.

Second, because I doubt I am good at market timing, I simply try to allocate my cash at the best valued companies at the moment. I find these best companies by looking at dividend streaks, historical earnings and dividend growth, competitive advantages and existing portfolio positions. Once I have cash on hand, I try to purchase best values available, by taking into account valuation, prospects, and portfolio weights. I therefore try to buy shares every month or so. I do search for values, and although could sacrifice on a dividend streak or minimum yield, I would never sacrifice on quality and valuation. As long as I can find bargains, I would keep doing so.

For example, during the late 1990s, many quality dividend growth stocks such as Coca-Cola (KO), Wal-Mart Stores (WMT) and Johnson & Johnson (JNJ), became grossly overvalued. However, astute dividend investors could have found attractive values in REITs, financials and energy for example. In addition, there were pockets of opportunity from time to time in sectors that temporarily went out of favor such as tobacco for example.

Third, I try to allocate money whenever I get them, because I do not want to miss out on the power of compounding. In theory, I could wait until the perfect price. In reality, I could end up missing out on the perfect price for a long period of time. Therefore, my money would not earn anything for me. For example, assume that my entry criteria requires to invest in a company yielding 3% in real terms. However, I could only find companies yielding 2%. What if I decided to put my money to work at 2%, but I could not find any 3% yielders for five years? It would take ten more years for an investment at 3%, to reach out the same amount of net worth as the 2% yielding one.

However, if you had a high allocation to cash in 2007 - 2008, you might have been able to deploy it very well at attractive valuations. Many otherwise quality companies were selling at ridiculously low valuations during this tumultuous time period. The risk of having too much cash however is that it might have been deployed too quickly, at the beginning of the crisis, rather than slowly.

In the present market, I find some great companies at low valuations, which unfortunately have imperfections. These imperfections are mostly low streak of dividend increases and low yields. I would hate to start breaking my rules on a more consistent basis however. This might be risky as I might end up overpaying in hindsight or buy something I should not have touched in the first place. I could overpay in hindsight if I purchase a cyclical with a low P/E, whose earnings decrease precipitously and then stay there. This could be the cause with many commodity companies. The list of companies that currently fit my entry criteria is dwindling as we speak, but unfortunately many of these are companies I already have a very high concentration into.

At this time, one of the cheapest sectors is oil and gas services. The three energy companies to consider today include:

ConocoPhillips (COP) explores for, produces, transports, and markets crude oil, bitumen, natural gas, liquefied natural gas, and natural gas liquids on a worldwide basis. The company has managed to increase dividends for 13 years in a row. Over the past decade, it has managed to boost distributions by 15.10%/year. Currently, the stock trades at 10.90 times earnings, and yields 4.20%. Check my analysis of COP.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has managed to increase dividends for 26 years in a row. Over the past decade, it has managed to boost distributions by 9.60%/year. Currently, the stock trades at 9.40 times earnings, and yields 3.10%. Check my analysis of Chevron.

Exxon Mobil Corporation (XOM) engages in the exploration and production of crude oil and natural gas, and manufacture of petroleum products. The company has managed to increase dividends for 31 years in a row. Over the past decade, it has managed to boost distributions by 9%/year. Currently, the stock trades at 9.40 times earnings, and yields 2.70%. Check my analysis of Exxon.

I would not advise putting more than 15-20% of one’s portfolio in a given sector however, in order to reduce risk. If oil prices fall back to the levels we saw during the financial crisis, and stay there for a few years, oil companies might be unable to continue with their generous share repurchases and dividend increases. This doesn't mean this would happen, but the intelligent dividend investor needs to think about probabilities, and build a portfolio that would not permanently lose value and income should a string of unfortunate activities materialize.

In addition, I have gotten a little more creative with companies I like, that are slightly overvalued. For example, I like shares of Coca-Cola, which are trading at a forward 2013 P/E of 19.15 and forward P/E of 2014 of 17.70.

Because I find the stock a little rich to my taste right now, I sold one January 2014 put, with a strike of 40, at around $1.85/contract. If the stock price trades below $40/share at the time of expiration, I would buy the shares at the strike price. However, my cost would be essentially $38.15. This equates to a P/E ratio of 18.20.

Furthermore, I also sold a January 2015 put with a strike of $40 at $4.30/contract. If exercised, this will translate into a cost basis of $35.70/share or a P/E of 15.70.

I like the long-term economics of Coca-Cola, which should benefit from rising demand in emerging markets and integration of North American bottling operations. The company has strong brand name, which provides pricing power and solid profitability. Check my analysis of Coca-Cola.

12 comments:

I have a separate account set up to accumulate savings. Every pay period a fixed amount gets withdrawn from my checking account and transferred to the savings account. Once my savings tops $1000 (roughly every 6 to 8 weeks) I transfer most of that money over to my investment account and buy some shares in whichever company I have decided is going to be my next dividend play.

I realize that there is a short-term risk of buying a stock when it is at a high, and then seeing it decline in value, but I am not investing for a short-term return. While it is nice to see my stocks appreciate in value, the truth is that I am primarily looking to buy future income via their dividends. A run-up in price is actually a negative for me from that perspective, since I will receive less shares when I automatically reinvest the dividends to grow my future earnings.

My final goal is to retire on or before my 67th birthday. That is a bit under 24 years from now. The income from my dividend portfolio is intended to cover most, if not all, of my day to day expenses in retirement, leaving the money in my 401k as a reserve. In the end, I feel sitting out of the market trying to time the "perfect" entry price for stocks is a bigger risk than buying today and holding for decades.

Great post. Because of the run-up in prices it looks as though most of us are in a similar boat. However, I don't mind paying a little bit over a 20 P/E for stalwarts like KO or JNJ, especially with a 30+ year time frame. Have you ever done, or considered writing, a post that goes into more detail re: puts and calls? I know I'd be interested to see how it is accomplished. Thanks.

Great question! As you've pointed out several times, a longer-term timeframe allows investors to focus their invest process on income related criteria rather than capital gains.

The more focus on price, the shorter the outlook. I'm sure some of the investors hoping for a correction wouldn't pull the trigger as stocks fell in price, citing the need to wait until the correction has run it's course!

Although caution is currently warranted with the broader market being modestly overvalued by most metrics (Shiller or market cap/GNP), there are still certain sectors that offer more value than others.

I pointed out recently that REITs and energy in particular have some value here, as many blue chip companies in both sectors have underperformed the broader market, some by significant margins.

It's best to stick to your strategy, but to also keep your options open when the traditional go-to stocks are richly valued.

And I'm with you on being a poor market timer. I'm willing to admit that I likely suck as much as everyone else, but I do know that I have what it takes to be an excellent buy-and-hold investor. I say stick to your strengths and minimize your weaknesses.

Thank you for stopping by. I am finding fewer good values today, as many stocks are above my buy range. I hope we do get declining prices over time, as I am in the accumulation stage also. Hope we both get to retire by our target times.

BidAskDividends,

Thank you for stopping by! I recently bought KO at 20 times forward earnings. However, I would much rather buy it at 16 times earnings. If you pay too much for a stock, you have a lower margin of error.

I have written information on options, and have started playing around with naked puts this year with some limited success. I do go back and forth on selling options, as it does look very similar to gambling to me. Check my archives for types of articles I have written before:

Thank you for reading. I am trying to keep looking for the long-term, which is very difficult, especially since I am exposed to market information on an hourly basis - coworkers, news, newspapers, billboards, internet, etc. I screen based on price relative to value frequently. Luckily, before I buy stocks I tend to look at the business performance.

I hope we get a correction, but if not, that means I have to look even deeper into identifying overlooked dividend growth stocks. I would hate to start accumulating a sizeable nest egg of cash and cash equivalents. If I do not invest any of my future cash proceeds for the next 12 months, I would probably end up with a pretty high cash allocation.

Thanks for stopping by. I honestly do not pay attention to Schiller, because this P/E of 10 years is largely a lagging indicator. I look at this year's earnings and next year expectations. So many stocks like CL or KMB are slightly overvalued.

I struggle to find reasons why market cap over GNP is a useful indicator. Why is it an indicator of anything anyway?

I agree there are values around, and have been buying just like you ;-) With our buying every month or so, we are destined to buy a few tops over our investing careers, but also a few bottoms too. It would all average out in the long run.

By the way, if stock prices fall from here, expect to hear more about "the end of dividend investing". I heard that in May and June a lot. I would love more stocks to fall in price, as that would allow me to buy quality at a discount.

Thanks for commenting. Oil is used in many other aspects of life, other than energy. I would think that even if solar and wind or other energy sources are developed, people would still use oil and natural gas for decades to come.

Just my opinion though, not a recommendation to buy or sell anything ;-)

"Second, because I doubt I am good at market timing, I simply try to allocate my cash at the best valued companies at the moment. I find these best companies by looking at dividend streaks, historical earnings and dividend growth, competitive advantages and existing portfolio positions"

Isn't trying to allocate cash at "the best valued companies" the definition of market timing?

It would be nice if/when Electric vehicles replaced gasoline and diesel, but that isn't about to happen for quite a while.

1. The infrastructure isn't in place. You can find gas stations all over the place, but locations to charge your EV while on the road are few and far between at the moment.

2. Electric Vehicles don't make as much economic sense as most people assume. The Nissan Leaf averages 3 miles for every kWh of electricity, roughly 3 cents a mile depending upon your local electric cost. My car averages 35 MPG, or roughly 10 cents a mile. But wait, the Leaf has a battery replacement cost that quickly adds up! Nissan is pressuring Leaf owners to buy a "battery replacement" plan at $100 a month. If you drive 2,000 miles a month (my average), that adds an extra 5 cents a mile to the price, bring you up to 8 cents a mile. If you drive less, the battery replacement charge pushes the price per mile even higher. Given that Nissan Leafs are seeing their batteries prematurely lose their capacity to hold a charge in warm climates and for drivers that drive more than Nissan's assumed average of 7,500 miles a year, you'd pretty much have to buy this battery plan or see your car turned into an expensive yard ornament in a short time. Plus there is the higher initial cost of the vehicle itself.

3. There is a HUGE installed base of Gasoline and Diesel vehicles. It will take decades (plural) to replace them all, even if every car and truck assembly line were shifted to producing only EVs. We can't build cars and trucks fast enough to quickly replace them all.

4. Finally, even when the EV manufacturers work out the issues of price, maintenance and adequate charging facilities are finally available around the country, just where do you think all of that electricity to run those cars will come from? Mostly Oil, Natural Gas and probably still some Coal. Wind Farms are being challenged in court by neighbors who don't want their views cluttered up with huge towers, solar farms take large tracts of land, and both are intermittent sources of power at best (no solar at night or on cloudy days, no wind power on calm days or, ironically enough, on very windy days).

Even if and when use of Oil and NG for fuel begins to fade, it's still needed to produce fertilizers, dyes for clothing, medicines, most plastics such as the keyboard I am using to type this message, etc.

I don't foresee much "doom" for the Oil & Gas companies anytime soon. They will simply adapt and continue to make profits.

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